How Appliance Recycling Centers of America Inc (NASDAQ:ARCI) Delivered A Better ROE Than Its Industry

Appliance Recycling Centers of America Inc (NASDAQ:ARCI) performed in-line with its specialty stores industry on the basis of its ROE – producing a return of14.45% relative to the peer average of 12.05% over the past 12 months. But what is more interesting is whether ARCI can sustain this level of return. This can be measured by looking at the company’s financial leverage. With more debt, ARCI can invest even more and earn more money, thus pushing up its returns. However, ROE only measures returns against equity, not debt. This can be distorted, so let’s take a look at it further. See our latest analysis for Appliance Recycling Centers of America

Breaking down Return on Equity

Firstly, Return on Equity, or ROE, is simply the percentage of last years’ earning against the book value of shareholders’ equity. For example, if the company invests $1 in the form of equity, it will generate $0.14 in earnings from this. Investors seeking to maximise their return in the Specialty Stores industry may want to choose the highest returning stock. However, this can be deceiving as each company has varying costs of equity and debt levels, which could exaggeratedly push up ROE at the same time as accumulating high interest expense.

Return on Equity = Net Profit ÷ Shareholders Equity

ROE is assessed against cost of equity, which is measured using the Capital Asset Pricing Model (CAPM) – but let’s not dive into the details of that today. For now, let’s just look at the cost of equity number for Appliance Recycling Centers of America, which is 10.70%. This means Appliance Recycling Centers of America returns enough to cover its own cost of equity, with a buffer of 3.75%. This sustainable practice implies that the company pays less for its capital than what it generates in return. ROE can be dissected into three distinct ratios: net profit margin, asset turnover, and financial leverage. This is called the Dupont Formula:

Dupont Formula

ROE = profit margin × asset turnover × financial leverage

ROE = (annual net profit ÷ sales) × (sales ÷ assets) × (assets ÷ shareholders’ equity)

ROE = annual net profit ÷ shareholders’ equity

NasdaqCM:ARCI Last Perf Feb 27th 18
NasdaqCM:ARCI Last Perf Feb 27th 18

Basically, profit margin measures how much of revenue trickles down into earnings which illustrates how efficient the business is with its cost management. Asset turnover reveals how much revenue can be generated from Appliance Recycling Centers of America’s asset base. The most interesting ratio, and reflective of sustainability of its ROE, is financial leverage. We can assess whether Appliance Recycling Centers of America is fuelling ROE by excessively raising debt. Ideally, Appliance Recycling Centers of America should have a balanced capital structure, which we can check by looking at the historic debt-to-equity ratio of the company. The ratio currently stands at a sensible 15.07%, meaning Appliance Recycling Centers of America has not taken on excessive debt to drive its returns. The company is able to produce profit growth without a huge debt burden.

NasdaqCM:ARCI Historical Debt Feb 27th 18
NasdaqCM:ARCI Historical Debt Feb 27th 18

Next Steps:

ROE is one of many ratios which meaningfully dissects financial statements, which illustrates the quality of a company. Appliance Recycling Centers of America’s above-industry ROE is encouraging, and is also in excess of its cost of equity. ROE is not likely to be inflated by excessive debt funding, giving shareholders more conviction in the sustainability of high returns. Although ROE can be a useful metric, it is only a small part of diligent research.

For Appliance Recycling Centers of America, I’ve compiled three key factors you should look at below. Just a heads up – to access some parts of the Simply Wall St research tool you might be asked to create a free account, but it takes just one click and the information they provide is definitely worth it in my opinion.

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